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A direct approach to Chinese equities for risk inclined investors

Following my recent visit to Guangzhou, Shenzhen and Hong Kong I believe that it is now time for “risk incline investors” to re-examine their trading and investment strategies. While investors had hoped that a permanent and sustainable solution to the eurozone crisis would have been implemented by now, it is increasingly clear that there is no end of the crisis in sight. Longer-term, I believe a "new European order" will emerge, but it could be years. Until then, eurozone economic growth will suffer.

Michel Clérin
Michel Clérin
While I'm optimistic that the U.S. will eventually deal with the magnitude of its fiscal and economic growth issues, I also don't see solutions occurring in the near future.

I deem that the engine of global economic growth for the next five-year period will be China. I confidently think that it's not only appropriate, but critical for investors, even those whose focus is trading rather than investing to now take a look at China equities based on long-term investment horizons.

There are four key factors that investors need to consider when looking at China:
1. Economic prospects for the eurozone and United States
2. The U.S. Federal Reserve's continuing quantitative easing programs
3. Current and possible Chinese economic stimulus programs
4. Economic prospects for China

A - Economic Prospects for the eurozone and United States

While there are exceptions, it is difficult for companies in individual countries to grow at a rate greater than the growth rate of their country's economy. With this in mind, let's take a quick look at the eurozone and United States. While many of us have been hopeful that a solution to the eurozone crisis was in sight, it's now apparent that there is no short-term solution. This past summer I attended in New York a speech given by former U.S. Federal Reserve Chairman Alan Greenspan.
While much of the speech was in Greenspan "Fed Speak," what is relevant, and what I unquestionably agree with, were three key points:
1. Write off Europe for the foreseeable future
2. Citizens/voters will not endure short-term pain for long-term objectives. This applies primarily to Southern European countries including Spain, Italy, Portugal, and Greece, as well as more than likely, France.
3. Southern Europeans will never become "Germans."

These three items give one a quick and perhaps different outlook regarding the future for the eurozone.

The International Monetary Fund (IMF) is projecting eurozone GDP growth at a negative .4% for this year, and a miniscule .2% for next year, with a great variance of growth among individual countries.

Economic prospects are not as bleak for the U.S. as those for Europe, but not overly encouraging. My opinion is that due to structural issues in the U.S. economy, unemployment at a rate of around 8% or more has become the new normal, and high unemployment will be with the U.S. for a long time. Regardless of the outcome of the U.S. presidential election, the outlook for the U.S. for the next few years is not an optimistic one. The economic prospects for the U.S. are compounded by January's 2013 "fiscal cliff," which I suppose will be resolved by compromise between the Republicans and Democrats, just in the "nick of time," but result in members of both parties not being happy with the outcome.

This month the IMF projected U.S. GDP growth of 2.1% for this year and 2.1% for next year. I believe that with the magnitude of the U.S. economy's structural issues, the prospects of the U.S. returning to economic growth above 3% in the next few years is incredibly unlikely. When you look at the economic growth of the both the U.S. and Europe, all investors must also consider the ugly specter of inflation. The IMF has projected consumer inflation in "advanced economies," which includes the U.S. and Europe, of 2.7% for this year and 1.6% for next year. I think that the likelihood of a significantly greater rate of inflation is substantial. Keys to future inflation will also be whether the European Central Bank (ECB) and the Fed are able to significantly shrink their bloated balance sheets as economic growth returns somewhere. The "somewhere" is, I believe, likely to be China and not the U.S. nor the eurozone.

When one takes into consideration inflation, the GDP growth prospects for both the eurozone and the U.S. are even bleaker than they at first appear to be. Taking into account inflation and based on the IMF economic growth data, there will be negative real growth for all of this year, as well as for 201 for both the eurozone and United States. And, I believe that inflation is likely to be substantially higher than the IMF is projecting for 2013 and beyond.

B- The U.S. Federal Reserve's Quantitative Easing Program

The U.S. Federal Reserve's latest round of quantitative easing or QE3 is creating collateral damage in emerging markets. Whether this was a planned objective is unclear. But, QE3 is providing opportunities for investors who have a global perspective. QE3 consists of the Fed purchasing up to US$40 billion of mortgage debt each month. The Fed has indicated that this will remain in place until the outlook for jobs in the U.S. improves "substantially." With the U.S. being in the midst of the campaigning for the presidential election, China has emerged as a convenient scapegoat. China bashing is part of the daily campaigning rhetoric by both candidates, President Obama and Former Governor Romney. With the strong business and financial integration of the U.S. and China, this rhetoric is definitely not in the best long-term interests of the U.S.

I think it's naive to believe that the U.S. Federal Reserve is an independent body, one that is immune to political pressure and public opinion. While differences of opinions have been voiced, many see as a lack of positive impact on U.S. economic growth and on employment from the Fed's quantitative easing programs to date. Opinions are also being voiced that the Fed's quantitative easing programs are reactions to public and political pressure, and that the latest QE3 has more to do with an American-Chinese trade war than the key direct beneficiary being the U.S. economy. It has been suggested by some economists that QE3 was more about a Chinese-American trade war than a stimulus program for the U.S. economy. Confirming this position was China's Vice Foreign Minister Cui Tiankai, when he spoke in Brussels on the 21 st of October. He indicated that the Fed's latest round of quantitative easing is adding to financial market instability and inflationary pressure in emerging market.

In response to concerns raised by countries including Russia, Brazil and China, Federal Reserve Chairman Ben Bernanke said last week that it was unclear to the Fed that it’s highly stimulative monetary policies were hurting emerging economies. Bernanke bluntly called for "certain" emerging economies to allow their currencies to rise, with a consequence being an increase in the cost of their exports to importing countries, including specifically to the U.S. Although he didn't mention China, his comments were definitely directed to China.

C- Economic Prospects for China

Earlier this month, the IMF projected China's economic growth for this year at 7.8% and for next year at 8.2%. While 7.8% growth is the weakest in more than three years, industrial production, retail sales and fixed-asset investment all accelerated in September. This and other indicators, including recent increases in the prices of certain commodities including iron ore, are signaling that China's growth may be rebounding after a seven-quarter slowdown. It also reflects China's strategy of seeking to rely less on exports for growth, and increasingly more on the country's domestic economy. When you compare China's GDP growth of 7.8% to that of the eurozone and the U.S., one has to admit that China's growth is incredible in today's global economic and financial environment.

D-.Current and Possible Chinese Stimulus Programs

China's recent infrastructure stimulus, totaling US$158 billion, with its focus on the domestic economy, should stimulate consumer spending and the country's important manufacturing sector. This stimulus program is seen as benefiting consumer buying and internal Chinese economic growth as opposed to export-driven industries. Additionally, China's money supply has recently grown as Beijing has pumped more funds into its economy. While questions have been raised as to why the Chinese government hasn't taken more stimulus steps, I believe that the main reason is that existing leadership doesn't want to leave the country's new leadership with a legacy stimulus program that could prove to be problematic for the new government.

After the November 8th change in China's senior leadership, I anticipate additional measures will be taken to stimulate the country's economy, but these may not "kick in" until China's new leadership has time to "get its feet on the ground" and create its own programs, which I see as occurring late fourth quarter of this year, at the earliest, and more likely the first quarter of next year.

With the continuing economic problems of the U.S. and eurozone, it's appropriate to look at investments in "countries that are working." This immediately leads one to China.

I believe that now is the time to take a look at Chinese equities, not from a short-term trading perspective, but instead from a medium- to long-term investment strategy, a strategy for the next three to five years.

Emerging market equity funds tracked by EPFR Global Research indicated that the week ended October 17th was the sixth straight week of investment inflows. EPFR also indicated that the total inflows into emerging markets were $21 billion so far this year. EPRF also indicated that inflows into China equity funds also reached a seven-week high. Investors have started returning to China, despite all the inherent issues of investing in emerging markets in general and China, specifically.

With the Chinese economy likely having bottomed out, and with the valuations of Chinese companies that trade in the U.S. being very low, I believe that it's appropriate for “ risky type of investors” to take a fresh look at Chinese equities that trade in the U.S. This, I believe should be done not from a short-term perspective, but from a longer-term perspective.

In analyzing Chinese companies that meet a few general criteria like: positive trends in revenue and income; low PEs; companies that are focused on internal Chinese demand rather than export; and companies with good growth prospects for the future.

Some of the companies that I believe meet these criteria are:
1- Xiniya Fashion Inc. (XNY) designs, manufactures and sells men's clothing and accessories. For the quarter ended June 30th, the company showed an increase in revenue of almost 25% to nearly $25 million. But despite the increase in revenue, net income for the quarter was almost $3.2 million, a 43% decrease compared to the second quarter of 2011, due to primarily increased selling and distribution costs. My conclusion is that the company has already started reining in these costs, and that the likely decrease in these costs will be reflected in the company's third and fourth quarter results, making the company a definite candidate to be considered for investment. Its PE is 1.55.

2- China Carbon Graphite (CHGI.OB) is one of the country's leading wholesale suppliers of fine grain and high purity graphite, and a top overall producer of carbon and graphite products. Its revenues for the second quarter were $11.88 million, and its net income was $870,000. Its PE is 4.75.

3- Asia Carbon Industries' (ACRB.PK) principal product is carbon black, which is primarily used as a key raw material in the manufacture of tires. The future of Asia Carbon Industries' business is tied to the growth of the tire industry in China, and to the growth of China's auto industry as well. The company's revenues for the second quarter of this year were $13.195 million, which, on an annualized basis, is slightly more than the $49.12 million the company reported for all of 2011. The company's net income for the second quarter of this year was $1.87 million. Its PE is 1.41.

4- China Green Agriculture Inc. (CGA) produces and distributes humic acid-based compound fertilizers, other varieties of compound fertilizers and agricultural products. All of its products are certified by the Chinese government as "Green Food Production Materials," as defined by the China Green Food Development Center. For the first six months of this year, its sales increased 21% to $217.5 million, net income increased 27.5% to $42 million and the company had earnings per share of $1.56, which beat company guidance. Most importantly, the company provided guidance indicating that it would continue to grow during the rest of this year. The company has forecast revenues of at least $238 million, net income of at least $46.2 million, and earnings per share of at least $1.68 for the full year of 2012. Its PE is 2.18.

5- China Recycling Energy (CREG) provides environmentally friendly waste-to-energy technologies to recycle industrial byproducts for steel mills, cement factories and coke plants in China. Byproducts include heat, steam, pressure, and exhaust to generate large amounts of lower-cost electricity and reduce the need for outside electrical sources. The company's net income in the second quarter was $1.2 million or $0.03 per share, a decrease from $3.7 million, or $0.07 per share, for the second quarter of 2011. Its PE is 3.31.

6- China Automotive Systems (CAAS). Through eight joint ventures in China, the company manufactures and sells power steering components and systems to China's automotive industry, and also exports to North America. The company is the largest power steering manufacturer in China's domestic market. For the second quarter of this year, the company's sales increased 2.8% to $80.4 million. For the second quarter of this year, China Automotive Systems' net income was $8.6 million, up from $7.2 million for the second quarter of 2011. Its PE is 7.11.

Other Chinese companies that I believe meet the above criteria and are worthy of investment consideration are SinoCoking Coal and Coke Chemical Industries Inc. (SCOK), Longwei Petroleum Investment Holding Ltd. (LPH) and Xinyuan Real Estate Co. (XIN).

There is no question that investing in smaller-capitalization companies, as well as investing in companies in emerging markets, specifically those in China, are not suitable for all investors, and can be very risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risk.
All of the companies mentioned are U.S. reporting issuers, and subject to the reporting requirements of the U.S. Securities and Exchange Commission, so U.S. transparency and disclosure is available to investors, and most are subject to the listing requirements and standards of the NYSE and NASDAQ.


Michel Clerin

Mardi 13 Novembre 2012

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